At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

For a more detailed explanation of bond pricing and yield calculations, check out Advanced Bond Concepts.

  1. What is the difference between a zero-coupon bond and a regular bond?

    The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons, or interest ... Read Answer >>
  2. How does an investor make money on a zero coupon bond?

    Learn about investing in zero-coupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >>
  3. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  4. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
  5. Should investors focus more on the current yield or face value of a bond?

    Find out when investors should focus on a bond's current yield versus its face value, including an example of how current ... Read Answer >>
  6. How does face value differ from the price of a bond?

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
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